The State of Small Business Lending: Innovation and ...

The State of Small Business Lending: Innovation and Technology and the Implications for Regulation

Karen Gordon Mills Brayden McCarthy

Working Paper 17-042

The State of Small Business Lending: Innovation and Technology and the Implications for Regulation

Karen Gordon Mills

Harvard Business School

Brayden McCarthy

Fundera, Inc.

Working Paper 17-042

Copyright ? 2016 by Karen Gordon Mills and Brayden McCarthy Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author.

THE STATE OF SMALL BUSINESS LENDING:

INNOVATION AND TECHNOLOGY AND THE IMPLICATIONS FOR REGULATION

Karen Gordon Mills Brayden McCarthy

Karen Gordon Mills is a Senior Fellow at Harvard Business School focusing on U.S. competitiveness, entrepreneurship and innovation. From 2009 until 2013, she was Administrator of the U.S. Small Business Administration, and a member of President Barack Obama's Cabinet. Brayden McCarthy is Vice President of Strategy at Fundera, an online small business credit marketplace, and was formerly Senior Policy Advisor at the White House National Economic Council and the U.S. Small Business Administration.

Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder.

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TABLE OF CONTENTS

EXECUTIVE SUMMARY ................................................................................................................................................. 3 INTRODUCTION .......................................................................................................................................................... 10 CHAPTER 1: THE STATE OF THE SMALL BUSINESS ECONOMY: PRESSURES CONTINUE ..................................... 14 CHAPTER 2: THE GAP IN SMALL BUSINESS CREDIT: SMALL DOLLAR LOANS ....................................................... 24 CHAPTER 3: HOW TECHNOLOGY HAS CHANGED THE GAME: NEW ENTRANTS AND THEIR INNOVATIONS ......... 45 CHAPTER 4: WHO WILL BE THE WINNERS AND THE LOSERS: STRATEGIC ADVANTAGES OF INCUMBENTS VERSUS NEW PLAYERS ............................................................................................................................................. 59 CHAPTER 5: THE CURRENT U.S. REGULATORY ENVIRONMENT: SPAGHETTI SOUP .............................................. 86 CHAPTER 6: RECOMMENDED REGULATORY ACTION PLAN .................................................................................... 96 APPENDIX A: FEDERAL GOVERNMENT EFFORTS TO RESTORE CREDIT ACCESS FOLOWING THE `08 CRISIS...119 APPENDIX B: U.K. POLICY AND REGULATORY FRAMEWORK ................................................................................123

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EXECUTIVE SUMMARY

Small businesses are core to America's economic competitiveness. Not only do they employ half of the nation's private sector workforce ? about 62 million people ? but since 1995 they have created approximately 60 percent of the net new jobs in our country. Small businesses were hit especially hard by the Great Recession, accounting for over 60 percent of the total jobs lost, in part because the crisis was centered on the banking sector. Credit oriented crises are known to have a disproportionate effect on credit dependent entities such as small businesses.

In 2014, small businesses were still struggling to recover, prompting our first HBS Working Paper: "The State of Small Business Lending: Access to Credit During the Recovery and How Technology May Change the Game," which focused on a then controversial question: "Is there a credit gap in small business lending?" 1

One answer became clear: a gap in access to credit for small businesses did exist and was

particularly persistent in small dollar loans-- those defined as under $250,000. This finding is noteworthy, as this is the level of loan that most small businesses want; more than 70 percent of small businesses seek loans in amounts under $250,000, and more than 60 percent want loans under $100,000.

Not surprisingly, this was exactly the market targeted by a new set of lenders. Entrepreneurs and innovators saw the opportunity, and over the last several years have created an emerging, dynamic market of online lenders that use technology to disrupt the small business lending market. Though still small relative to the traditional bank market, these new competitors provide fast turnaround and online accessibility for customers, and use new data and credit scoring algorithms.

Over the past several years, the online lending market has exploded with rapid growth both in the proliferation of new companies and new product offerings and in terms of market

1 Mills, Karen G., and Brayden McCarthy. "The State of Small Business Lending: Credit Access During the Recovery and How Technology May Change the Game." Harvard Business School

Working Paper No. 15-004. July 2014.

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awareness and trial by small business borrowers. We call this phase the "wild west," as companies achieved record valuations in the public markets and some voiced the expectation that the day of the traditional banks was over, as the disruptors would capture large share and dominate the small business lending market.

It appears that this initial phase of new market activity is coming to an end with problems surfacing for leading players such as Lending Club, Prosper, and OnDeck. This paper explores the evolution of the new marketplace and describes what strategies, in the months to come, might differentiate the winners from the losers. We believe that we are now entering Phase II of the market, which is characterized by traditional players such as large lenders and community banks beginning to develop numerous and varied partnerships with online innovators, and by the entrance of "platform" players with large established customer bases.

As the online marketplace evolves, those who succeed will be the ones who have access to low-cost capital and those who can best access and serve the small business customer-- creating products that fit their needs and ensuring that small businesses find their way to the loans that work best for them. This will drive greater customer satisfaction and lower defaults, which is good for borrowers, lenders, and for small businesses' contribution to the U.S. economy.

Another critical question is: who should regulate this new market? If these innovators are the answer to filling the small business credit gap, how do we oversee a safe and robust market for borrowers and investors, and ensure this does not become another subprime market with detrimental impact for small businesses. We believe the time is right to define a clear path for appropriate regulatory oversight of the online lending market. This paper will describe the current regulatory environment, with its large number of agencies, each with overlapping

authority and mandates. As a result of the "spaghetti soup" of the current regulatory environment, small business lending has in many ways slipped through the cracks.

The emergence of "bad actors" and worrisome practices has gained the attention of a number of the regulatory bodies, many of who are actively commenting on and investigating the marketplace. The objective of this HBS White Paper is to provide a clear and detailed set of recommendations for regulatory activity that will protect borrowers and investors in the small business online lending market, and address concerns about systemic risk, while avoiding dampening the innovation that has proven so promising for filling the gap in small business access to credit.

This White Paper is laid out in three major sections: Chapters 1 and 2 describe the importance of small business to the U.S. economy and lay out the current state of access to credit for small businesses from traditional banks. Chapters 3 and 4 detail the fast growing new market for online lending to small business, and put forward our views on what strategies will differentiate the winners from the losers. We describe the multiple types of partnerships that are evolving between the new entrants and established players as the online market enters a new phase of its evolution.

Chapters 5 and 6 focus on the current U.S. regulatory environment and detail a Regulatory Action Plan with six recommendations we see as the most appropriate actions necessary to create a well-functioning and robust market for small businesses to access the credit they need in order to grow and create jobs. These chapters are summarized below:

Small businesses are critical to job creation in the U.S. economy.

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Small businesses create 60 percent of all net new jobs. Small firms employ half of the private sector workforce, and since 1995 small businesses have been responsible for about 60 percent of total net job creation.

Most small businesses are Main Street businesses or sole proprietorships. Of America's 30 million small businesses, 24 million are sole proprietorships. The remaining 5.8 million small firms have employees, and can be divided up into Main Street "mom-and-pop" businesses, small and medium-sized suppliers to larger corporations, and high-growth startups.

Small businesses were hit harder than larger businesses during the 2008 financial crisis, and were slower to recover from a recession of unusual depth and duration.

Between 2007 and 2012, the small business share of total net job losses was about 60 percent. In another troubling trend, the level of new business startups declined abruptly in the Great Recession, and has never fully recovered. New business starts went from 525,424 in 2007 to 403,902 in 2014. And the rate of new businesses-- those less than one year old--as a percent of total U.S. businesses has continued a decline that began over 30 years ago. This is concerning, as new businesses are an important source of job creation and vitality in the economy.

Bank credit is one of the primary sources of external financing for small businesses-- especially Main Street firms--and is key to helping small firms maintain cash flow, hire new employees, purchase new inventory or equipment, and grow their business.

Financial crises tend to hit small firms harder than large firms. As the academic literature underscores, small firms are always hit harder during financial crises because they are more dependent on bank capital to fund their growth.

While online lenders have begun competing for small business loans, the vast majority of loans still come from banks. Small banks are a key source of loans, with 52 percent of firms applying to small banks compared to 42 percent who are applying for loans from large banks.

Small banks have a higher approval rate for small business loans, with a 76 percent approval rate versus 58 percent for larger banks. Not surprisingly, small banks therefore have the highest satisfaction ratings, with an extraordinary lender satisfaction score of 75 percent. This underscores the importance of the lending relationship and its value to small business owners.

Though some of the cyclical barriers to lending have improved during recent years, a number of structural barriers continue to impede bank lending to small businesses, including consolidation of the banking industry, high search costs, and higher transaction costs associated with small business lending.

A decades-long trend toward consolidation of banking assets in fewer institutions is eliminating a key source of capital for small firms. Community banks are being consolidated by bigger banks, with the number of community banks falling to just over 5,000 today, down from over 14,000 in the mid-1980s, while average bank assets continues to rise.

Search costs in small business lending are high, for both borrowers and lenders. It is difficult for qualified borrowers to find willing lenders, and vice versa. Federal Reserve research finds that it takes small business borrowers an average of 24 hours to research and apply for bank loans and that they often approach multiple banks during the application process.

Smaller business loans, particularly those under $250,000, are considerably less profitable

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than large business loans and are therefore less appealing to banks.

Assessing creditworthiness of small businesses can be difficult due to information asymmetry. Little, if any, public information exists about the performance of most small businesses, in part because they rarely issue publicly traded equity or debt securities. Community banks have traditionally placed greater emphasis on relationships with borrowers in their underwriting processes, but these relationships are expensive.

The data on small business credit is limited but clear signs indicate that a gap in access to credit exists ? in small dollar loans.

Due to many of the structural issues described above, one would expect that the smallest of small firms would be much more likely to feel credit constraints. This divergence in credit availability was confirmed by data in the 2015 Federal Reserve survey, where micro-firms, those with revenues under $100,000, were half as likely to receive the financing they requested than firms with over $10 million in revenues.

In addition, approval rates for the smallest firms, those under $100,000 in revenue, were 70 percent versus the 90 percent for the largest firms. Interestingly, there is a direct correlation between size and approval rate across all firms measured. This result is not surprising given that smaller firms are more risky and often have fewer assets with which to collateralize the loan.

Another complicating factor for small firms is that they are seeking small dollar loans. Over 70 percent of small businesses are looking for loans of under $250,000. And more than 60 percent want loans of under $100,000. Unfortunately, banks have more and more often turned their efforts toward the more profitable, larger loan segments, and moved away from small dollar lending.

Seeing this opportunity, a large and growing number of new online lenders and marketplaces have emerged, which have opened up new pools of capital for small businesses through greater innovation in how small business loans are evaluated, underwritten, and managed.

New online marketplaces are disrupting the traditional market for small business loans. New tech-based alternative lenders are providing easy to use online applications, rapid loan underwriting, and a greater emphasis on customer service. Many are developing datadriven algorithms to more accurately screen creditworthy borrowers.

In the first phase of the online market growth, several models emerged and the market exploded with new entrants.

In this paper, we describe six categories of new entrants: balance sheet lenders, peer-to-peer platforms, multi-lender marketplaces, invoice and payables financing, payments/e-commerce platforms, and data providers, though the lines between many strategies are blurring. Players such OnDeck and Kabbage started by using their own balance sheets and then began raising capital from institutional investors, including hedge funds. Peer-to-peer platforms such as Lending Club, Prosper, and Funding Circle connect capital from institutional and retail investors to interested borrowers. Multi-lender marketplaces such as Fundera, Lendio, and Intuit provide online marketplaces which connect borrowers with a range of traditional and alternative lenders.

Invoice and payables financing is a robust new category replacing traditional factoring. Small business owners often have limited cash buffers and can benefit from being able to even out their working capital cycles. Players like Fundbox, BlueVine, and NOWaccount specialize in the

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